Month: December 2010

The negative reaction by many in the financial industry to this New York Times article critiquing the structure of over the counter derivative markets motivates me to make a very simple point: Economic theory makes it clear that there is no reason to believe that trading activity will be socially beneficial when the market structure is as described in the article.

Elementary economics tell us that in order for the invisible hand of the market to work, pricing (including bids and offers) must be transparent. That is, economics is explicit that it is only where there is public information about prices that self-interested behavior is socially beneficial or that the ability to make money on the market is an indicator that a valuable service is being provided to the economy. [Ask any economist to explain a competitive equilibrium to you and you will find that good price information is a necessary condition for “first-best” social welfare to be achieved.]

Because transparent pricing is a pre-requisite to market trade having positive implications for society as a whole, if economists ruled the financial world these would be the foundational principles of the marketplace:

1. [Enforceability of pricing regulations] In general contracts that are not traded on SEC or CFTC regulated trading forums are unenforceable. (Note that this is a revitalization of the reforms enacted during the Depression by the passage of the Securities Exchange Act and the Commodities Exchange Act. Note also that I recognize the need for limited exceptions to this rule.)

2. [Price transparency pre-trade] Best bid and offer prices posted by market makers and other traders on all trading forums are publicly available in real time. Market depth information is also publicly available in real time. The cost of providing this data to the public is covered by a fee proportional to trade on the market (e.g. a penny per $100 traded).

3. [Price transparency post-trade] All completed trade data (item, time, price and quantity) on all trading forums is publicly available.

4. [Meaningful prices] All bids and offers have a minimum duration of one minute.